Just prior to the start of COP26, the PRA published a report which, amongst other things, explores the relationship between climate change and the banking and insurance regulatory capital regimes. The report considers whether regulators can justify using regulatory capital requirements to reward exposures to green assets or counterparties or to penalise those exposures which are more carbon-intensive.
A key finding is that capital frameworks should not be used in this manner to address the causes of climate change. Whilst it is acknowledged that central banks and regulators do have an important role to play in supporting governments to achieve a transition to net zero, the PRA considers that the use of other policy tools is more effective and appropriate.
Why not use regulatory capital?
First, it is judged unlikely that changes to capital requirements would be effective in changing behaviour unless “calibrated at more extreme levels”: capital requirements are only one driver of decisions by financial firms. Additionally it is difficult to differentiate capital requirements based on specific underlying activities since entities often mix green projects in with other non-green activities, especially when transitioning to a greener business mix. Taking a realistic view, the PRA notes that even if penalising factors worked and banks and insurers withdrew from certain markets, other non-regulated investors might fill the gaps with no discernible benefit for the environment. Therefore the PRA prefers to focus its efforts on “ensuring firms adopt a strategic approach to managing climate-related financial risks”.
Second, there could be unintended consequences. In particular, would environmental considerations override other prudential risks which could threaten the safety and soundness of firms, or even lead to financial stability concerns? Just because an investment is considered green does not mean it is otherwise less risky and rewarding environmental considerations might lead to green investments receiving too generous a capital treatment given the inherent risk of the investment. Which should carry the higher capital charge - a loan to a AAA-rated carbon-intensive company or a thinly-capitalised green start-up company? Penalising factors may also work against transition to a green future: companies which aren’t green today, will need investment to become green in the future.
What should be done?
However, the PRA notes that the existing capital framework can be used to mitigate the impact of climate-related risks: “regulatory capital is not the right tool to address the causes of climate change (greenhouse gas emissions), but should have a role in dealing with its consequences (financial risks)” said Sam Woods, CEO of the PRA and Deputy Governor for Prudential Regulation, Bank of England.
The report considers how the existing capital frameworks capture and hold capital against climate risks (e.g. through risk assumptions in the internal ratings-based approach or pillar 2 add-ons for banks and within insurers’ internal models) and identifies three types of gaps within these current frameworks:
- “capability” gaps: which exist mainly due to a lack of granular data or limitations in modelling techniques;
- “microprudential regime” gaps: those fundamental to the way current regimes and methodologies address firm-specific exposures. In particular the reliance on historic data may understate future risks associated with climate change; and
- “macroprudential regime” gaps: possible gaps in the way system-wide exposures to climate-related financial risks are treated e.g. current tools only deal in a limited way with risks that increase over time or the lack of system-wide buffers in the insurance framework.
The PRA notes that its appetite to make changes “is greater where there are material gaps in the frameworks” but that this materiality is hard to determine given that the regulatory metrics are driven by accounting numbers, which themselves might not capture climate-related financial risks in full. More research and analysis are key to assessing these issues and the Bank of England will issue a Call for Papers and host a research conference on the topic in Q4 2022.
The PRA contributes its “early thinking” to address the identified gaps by suggesting areas for further consideration. However it notes that its work is part of international efforts to understand the issue and to develop options to mitigate any gaps in the current regulatory capital frameworks. It is leaving it up to politicians and policymakers to address the causes of climate change: the role of financial regulators is to provide resilience in the financial system against the consequences if they do not do so.
To this end the PRA makes clear that in 2022 it intends to switch its supervisory approach from one of assessing firms' implementation of its climate-related supervisory expectations to actively supervising against those expectations, and firms will be expected to demonstrate effective management of climate-related financial risks through regular supervisory engagements and reviews. If the PRA considers that progress is insufficient it will consider exercising its supervisory powers and its wider supervisory toolkit including capital scalars, capital add-ons and s.166 skilled persons reports. The nascent nature of the analytical framework and the data gaps will not excuse firms from acting on the PRA's climate-related expectations.
“regulatory capital is not the right tool to address the causes of climate change (greenhouse gas emissions), but should have a role in dealing with its consequences (financial risks)” said Sam Woods, CEO of the PRA and Deputy Governor for Prudential Regulation, Bank of England